On the Gutting of Financial Services Reform

Bloomberg has a well done but disheartening account of the watering-down-to-meaninglessness of financial services industry reform, with the case example being Basel III. Basel III is the latest iteration of capital standards for banks, which is hoped to be implemented more or less true to form by various national bank regulators. Richard Smith has been ably covering the substance of this beat (see here and here for earlier posts) and the details are indeed more that a bit convoluted.

However, Basel III has been touted in the US as the fix for the shortcomings in bank reforms such as Dodd Frank. As Treasury argues, if banks have more than enough capital, you have a lot of room for error on other fronts. But Basel III preserves too many bad ideas of its predecessor, Basel II, such as risk-weightings for various types of assets that lend themselves to gaming; along with risk weighting, a preservation of the problematic role of unreformed rating agencies; allowing big banks to use their own idiosyncratic and often widely varying risk metrics; an obsession with the asset side of the balance sheet, and not enough to the way that liabilities can also blow out when asset prices are under stress. Basel III thus preserves the architecture of Basel II. Andrew Haldane of the Bank of England described how regulation could best contend with a world of uncertainty, meaning risks that cannot be measured:

The financial system may operate in an environment of uncertainty, in the Knightian sense, as distinct from risk.

There is a literature on how best to regulate systems in the face of such Knightian uncertainty. It suggests some guideposts for regulation of financial systems. First, keep it simple. Complex control of a complex system is a recipe for confusion at best, catastrophe at worst. Complex control adds, not subtracts, from the Knightian uncertainty problem. The US constitution is four pages long. The recently-tabled Dodd Bill on US financial sector reform is 1,336 pages long. Which do you imagine will have the more lasting impact on behaviour?

Second, faced with uncertainty, the best approach is often to choose a strategy which avoids the extreme tails of the distribution. Technically, economists call this a “minimax” strategy – minimising the likelihood of the worst outcome. Paranoia can sometimes be an optimal strategy….

Third, simple, loss-minimising strategies are often best achieved through what economists call “mechanism design” and what non-economists call “structural reform”. In essence, this means acting on the underlying organisational form of the system, rather than through the participants operating within it. In the words of economist John Kay, it is about regulating structure not behaviour…

Glass-Steagall was simple in its objectives and execution. The Act itself was only 17 pages long. Its aims were shaped by an extreme tail event (the Great Depression) and were explicitly minimax (to avoid a repetition). It sought to achieve this by acting directly on the structure of the financial system, quarantining commercial bank and brokering activities through red-line regulation. In other words, Glass-Steagall satisfied all three robustness criteria. And so it proved, lasting well over half a century without a significant systemic event in the US.

The contrast with Basel II is striking. This was anything but simple, comprising many thousands of pages and taking 15 years to deliver. It was calibrated largely to data drawn from the Great Moderation, a period characterised by an absence of tail events – more minimin than minimax. Basel II was underpinned by a complex menu of capital risk weights. This was fine-line, not red-line, regulation. In short, Basel II satisfied few of the robustness criteria. And so it proved, overwhelmed by the recent crisis scarcely after it had been introduced.

Now a set of rules this elaborate and complex is also a ripe target for lobbying, particularly when it is a new iteration of a largely familiar system. The incumbents know well what the various choke points and how they might obtain relief from them. They may also have a keener appreciation than their minders of how the whole can be greater than the sum of the parts, how a combination of seemingly minor tweaks can give them a tremendous amount of latitude.

But that view presupposes that regulators had their hearts in coming down hard on the banks. It’s remarkable how, despite continuing high unemployment and yawning government deficits in virtually all major economies, that the meltdown of 2008 is regarded as an artifact of the distant past, apparently of sufficiently little consequence as to merit tough action now. The Bloomberg piece describes, admittedly at a high level, how Basel III was watered down. It’s told from the vantage of the battles Shiela Bair lost; query what other skirmishes were therefore overlooked.

Banks carried out a yearlong campaign to blunt international regulations, arguing that efforts to rein them in would curb lending and impede economic recovery. The lobbying effort was led by the Institute of International Finance, which represents more than 400 financial firms around the world and is chaired by Josef Ackermann, Deutsche Bank AG’s chief executive officer. Ackermann and other IIF members wrote hundreds of letters to the Basel committee, met with regulators and addressed forums from Seoul to Washington.

In June, the group published a report estimating that the proposed capital rules would result in 9.7 million fewer jobs being created and erase 3.1 percent of global economic growth — estimates the Basel committee later challenged…

Banks also reached out to their home regulators, arguing that some rules would disadvantage them more than other nations’ lenders. That helped draw the battle lines inside the Basel committee, according to an account pieced together from interviews with half a dozen members…

The committee agreed in July to narrow the definition of what counts as bank capital, focusing on common equity, which includes money received for selling shares and retained earnings….

The capital requirements might have been stricter had it not been for Greece. Escalating concern that the country wouldn’t be able to service its debt, culminating in a May bailout by the European Union and a $1 trillion rescue package for other member states that may need it, darkened prospects for economic recovery. That led some committee members to bend to bank pressure, according to policy makers, central bankers and others involved in the process.

Yves here. This is remarkable through-the-looking-glass logic. The cost of a financial crisis, in terms of lower future growth, is already baked in. Contrary to the urban legends taken to heart by bank regulators, dealing with banking crises ruthlessly, as in writing down assets, restructuring and recapitalizing sick banks, leads to a higher growth rate. Back to Bloomberg:

In addition to pushing for a higher capital ratio, Bair also argued for a global leverage ratio that would cap banks’ borrowing — something the U.S. has had on its books since the 1980s…

The EU may exclude the leverage ratio when it converts Basel rules into law next year. Several member nations have advocated dropping the rule, people close to the discussions said last month. A majority of the 27 EU countries oppose adopting the ratio, these people said.

“The argument is that this will restrain lending — I hope our colleagues in Europe don’t buy into this,” Bair said in an interview earlier this month.

Recent academic research supports Bair. A July paper by Jeremy Stein, a professor of economics at Harvard University, and two colleagues looked at data going back to the 1920s and found no correlation between higher capital ratios and costlier lending by banks. An October paper by Anat Admati and three other professors at Stanford University concluded that increased equity levels don’t restrict lending.

This result is not at all surprising, particularly since abuses promoted by Basel II have never gotten the airing they deserve. We discussed at some length in ECONNED how the so-called “negative basis trade” allowed traders at Eurobanks to reap multi-million dollar bonuses on profits not yet earned, and never to be earned, by buying and partially hedging AAA-rated CDOs. Those CDO exposures were not simply the reason so many banks nearly keeled over; this trader-driven demand for AAA CDOs helped keep the subprime market going well beyond its sell-by date, thus worsening the severity of the US housing bubble and aftermath.

But since there has been a singular lack of appetite to do adequate forensics into what caused the crisis, since it might prove to be embarrassing to people still in powerful positions, regulators can follow the inertial course of listening to the palaver that the financial services industry puts forward to allow it to continue looting.